A strangely compromised Linux box

A customer reported that a Linux machine used for ssh access (to in turn give telnet access to an ancient SCO machine) was refusing logins. I asked him to try logging in as root at the console; he was unable to do so.

When I arrived on site, I found that I could not login as he had said. I rebooted to single use mode and started peeking around. The machine had been hacked; there was little doubt about that. It's HOW it was hacked that bothers me,

First, there was no attempt to hide any evidence. I could see in wtmp and the secure logs that someone had logged in from a German ISP address, attained su status, and created a new su user for himself. He then changed root's password.

Fine so far, right? But then he did something very strange. He hand edited /etc/passwd and added "/nologin" at the end of each line except root and his own. This was what was preventing people from logging in.